In late March–timed to impress the G20–the Obama administration revealed its plan for regulating and restructuring the U.S. financial system. There were no surprises; its approach, presented by Treasury Secretary Timothy Geithner, endorsed both a single powerful systemic regulator, with authority to designate and regulate “systemically important” institutions in every financial sector, and a system for liquidating or bailing out financial firms that might cause a systemic breakdown if they failed. Although presented as a way to prevent a repeat of the current financial crisis, the proposals will, if implemented, seriously impair competitive conditions in all U.S. financial markets–enhancing the power of large companies that are designated as systemically important and threatening the survival of those that do not receive that endorsement. Underlying the plan is the erroneous belief–shattered by the catastrophic condition of the heavily regulated banking sector–that regulation can prevent risk-taking and failure. Although the plan could get through Congress if the financial industry remains inert and apathetic, the weakness of the administration’s case suggests that it is vulnerable to determined opposition.
The Obama administration and Congress are now filling in the details of a long-anticipated plan for reorganizing and restructuring financial regulation. It is no exaggeration to say that the proposal will create what are essentially government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac in every sector of the financial economy.
The principal elements of the administration’s plan are these:
* Establishing a federal agency as the systemic regulator of the financial system * Giving that agency the authority to designate “systemically important” financial institutions and establish a special regulatory structure for these firms * Providing a mechanism for the government to take control of financial institutions when and if it decides that their failure will create “systemic risk”
After its chilly reception of Treasury Secretary Tim Geithner’s bank-rescue plan, the market is now worried about nationalization. As well it should. Because if the Obama administration cannot come up with a viable plan to take troubled assets off their balance sheets, major banks will not recover and nationalization–a disastrous policy–might actually become the last resort.
Conventional wisdom in Washington is coalescing around the idea that the Federal Reserve should be empowered as a systemic risk regulator to supervise all “systemically significant” financial institutions. Last month’s Outlook contended that the failure of banking regulation argues strongly against extending safety-and-soundness regulation beyond the banking sector and that designating some firms as systemically significant would create another class of companies–like Fannie Mae and Freddie Mac–that are implicitly backed by the federal government. This Outlook examines the notion that the Fed should be the systemic regulator, pointing out that the agency has for many years had all the powers of a systemic regulator for banks and has failed to use them effectively; that supervising industries other than banking requires skills and knowledge that the Fed does not have and probably could not acquire in any reasonable amount of time; and that a role as systemic regulator would impair the Fed’s independence and create conflicts with its more important function as the nation’s monetary authority. Finally, this Outlook questions whether systemic risk itself can be defined–and whether the commonly accepted notion of systemic risk supports the creation of a systemic risk regulator.
For months, the media have been predicting that a strong new regulatory flux would emerge from the financial crisis. Now, with a new report by the dirigiste wing of the Group of Thirty (G30), we know what the future could look like. A good summary is that bank-like regulation would be spread beyond the banking industry. But there’s a problem: banks have been tightly regulated for years, both in the United States and Europe, and of all the institutions hurt by the financial crisis, they are in the most trouble. How do the bankers, academics, and financial policymakers who make up the G30 deal with this? They don’t. In the wake of this report, the principal question that Congress, the Obama administration, and the American people should ask is why regulation should be extended to most of the major players in the financial system when it has been a consistent failure for banks.
The ongoing financial crisis provides lessons that should be used to guide the redesign of our regulatory system. Recent proposals such as those of the Group of Thirty and the Congressional Oversight Panel do not appear to have recognized these lessons.
The government’s response to the weakening and failure of large financial institutions has been ad hoc and inconsistent. The Treasury and Federal Reserve decided to rescue Bear Stearns through a buyout by JPMorgan Chase; the negotiations were hurried and not well thought out. At the last moment, JPMorgan Chase had to raise its equity offer. Then, six months later, Lehman Brothers—an institution larger than Bear Stearns—was allowed to fail, raising uncertainty about both the true condition and the future treatment of other large investment and commercial banks. Within a few days, AIG was effectively nationalized and subsequently required unanticipated serial injections of capital.
Fair value accounting, introduced formally in 1993 by the Financial Accounting Standards Board (FASB), was intended to make financial statements easier to compare and balance sheets more reflective of real values. Instead, as applied by accountants in the current credit crunch, it has been the principal cause of an unprecedented decline in asset values and an unprecedented rise in instability among financial institutions. The system has to be rethought, not only because of its contribution to financial instability but also because its procyclicality tends to create asset bubbles and exacerbate the effects of their collapse.
Although the media are full of talk that we face a “crisis of capitalism,” the underlying cause of the financial meltdown is something much more mundane and practical–the housing, tax, and bank regulatory policies of the U.S. government. The Community Reinvestment Act (CRA), Fannie Mae and Freddie Mac, penalty-free refinancing of home loans, tax preferences granted to home equity borrowing, and reduced capital requirements for banks that hold mortgages and mortgage-backed securities (MBS) have all weakened the standards for granting mortgages and the housing finance system itself. Blaming greedy bankers, incompetent rating agencies, or other actors in this unprecedented drama misses the point–perhaps intentionally–that government policies created the incentives for both a housing bubble and a reduction in the bank capital and home equity that could have mitigated its effects. To prevent a recurrence of this disaster, it would be far better to change the destructive government housing policies that brought us to this point than to enact a new regulatory regime that will hinder a quick recovery and obstruct future economic growth.
The government takeover of Fannie Mae and Freddie Mac was necessary because of their massive losses on more than $1 trillion of subprime and Alt-A investments, almost all of which were added to their single-family book of business between 2005 and 2007. The most plausible explanation for the sudden adoption of this disastrous course–disastrous for them and for the U.S. financial markets–is their desire to continue to retain the support of Congress after their accounting scandals in 2003 and 2004 and the challenges to their business model that ensued. Although the strategy worked–Congress did not adopt strong government-sponsored enterprise (GSE) reform legislation until the Republicans demanded it as the price for Senate passage of a housing bill in July 2008–it led inevitably to the government takeover and the enormous junk loan losses still to come.
Credit default swaps (CDSs) have been identified in media accounts and by various commentators as sources of risk for the institutions that use them, as potential contributors to systemic risk, and as the underlying reason for the bailouts of Bear Stearns and AIG. These assessments are seriously wide of the mark. They seem to reflect a misunderstanding of how CDSs work and how they contribute to risk management by banks and other intermediaries. In addition, the vigorous market that currently exists for CDSs is a significant source of market-based judgments on the credit conditions of large numbers of companies–information that is not publicly available anywhere else. Although the CDS market can be improved, excessive restrictions on it would create considerably more risk than it would eliminate.
On September 7, the Treasury Department and the Federal Housing Finance Agency (FHFA) announced that the FHFA would take over both Fannie Mae and Freddie Mac (the GSEs) as a conservator for each company. As described by the FHFA, as a conservator it is empowered to put a company “in a sound and solvent condition.” […]